Stocks climb again on anticipation of a "solution" from Friday's European summit--should you sell on the news?

EuroZone leaders will announce something at their December 9 summit. There’s been enough activity this week involving German Chancellor Angela Merkel, French President Nicolas Sarkozy, Italian Prime Minister Mario Monti, European Central Bank President Mario Draghi, and International Monetary Fund general director Christine Lagarde to guarantee some sort of plan to address the continuing and worsening euro debt crisis will emerge from the summit.

Everyone knows that putting nothing forward would be a disaster.

We even have a good idea of the shape of a potential deal that would involve some kind of “fiscal compact” that promised tighter controls on national budgets, more austerity from Italy and Spain, a mechanism to leverage the European Financial Stability Facility—and, in return, more bond buying from the European Central Bank or from national EuroZone central banks channeled through the International Monetary Fund. (Italy sent a new austerity plan to parliament today, December 5.)

I think you can see the problem with that deal, right? Yep, too many moving parts that still need to be negotiated.

The big one, of course, is the nature of that fiscal compact. Would it require treaty changes? If so, that would put off agreement until sometime in 2012. Remember it took more than four months for euro member nations to approve the relatively minor changes required by the July agreement on expanding the powers of the European Financial Stability Facility. When German Chancellor Merkel talks about speedy approval in 2011, I have to wonder if she’s living on the same continent as the rest of EuroZone members. (The Irish, for example, can be seen to shudder visibly whenever the subject of treaty change comes up as they remember their country’s initial rejection of the euro in a national referendum.)

And, then, of course, there are the sticky problems of how much power member nations would give up over their national budgets (the French and Germans don’t agree on this) and the role, if any, in the process for countries such as the United Kingdom that belong to the European Union but not to the EuroZone.

Getting some kind of meaningful austerity program out of Spain on a tight time table is kind of tricky too since the new Spanish government doesn’t take power until December 13.

The plans to have the International Monetary Fund act as a conduit are troublingly vague. Would the funds come from the European Central Bank (less than a 30% chance in my estimation) or from the national central banks of EuzoZone (a 70% chance if this plan gets implemented at all.) And if the funds come from the individual national central banks how would those contributions be structured? Would other IMF members contribute? (Mexico and Brazil have said, yes, sort of, and the United States has said, no.)

Finally, let’s not forget that so far all we’ve heard from the European Central Bank is what amounts to hints that if EuroZone politicians achieved all this, the bank might act. We’ll know more about that after the bank’s meeting on Thursday, December 8. Right now the market is pricing in a 0.25 percentage point cut in the bank’s benchmark interest rate to 1%--despite recent reports that show inflation is running above the bank’s target rate of less than 2%.

But the critical indicator, bond traders seem to agree, is the term of the European Central Bank’s loans to European banks. Right now the longest term on such loans is one year. A move to two-year lending would be an indication that the bank is serious in following through on its hints of more involvement in ending the crisis. A jump to a three-yearn term would surprise the bond market with its aggressiveness.

So what should you expect this week?

I think the key to the week is the European Central Bank meeting on December 8. If the bank doesn’t cut rates by what the market now expects and leaves its lending term at one year, the bond market will almost certainly see that as a sign that the central bank isn’t going to up its intervention in support of Italian and Spanish bonds. If that’s the bank’s decision on Thursday, I’d probably decide to sell on Friday’s news from the summit in the belief that whatever the summit announces will be disappointing. If the European Central Bank cuts and moves to a two-year term, I’d give the Friday summit the benefit of the doubt and wait to see what comes out of the meeting. If the reaction and analysis over the weekend were negative, I’d think strongly about selling on Monday. If the central bank cuts and moves to three-year term, I think that markets will rally pretty much no matter what the summit announces. I’d hold on—as long as the actual results of the summit are vaguely credible.

What do I mean by “selling?” Selling European holdings certainly. Trimming risk-on positions that have rallied in the last week certainly. (You know, some of the stuff where you’ve got profits in the last week.) Cutting U.S. holdings of stocks, such as financials, that have shown strong linkage to the European crisis certainly

At this point I wouldn’t go further than that—unless the summit turns into a real disaster. Then I’d have to re-evaluate my exposure to even U.S. stocks and any core positions I’ve been building in emerging market stocks. The rally of the last week has been built on expectations for a solution with some substance coming out of the summit. If we can’t get something that can be characterized—even with charity—as that kind of solution, then, yes, I think you sell on the news.